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Capital adequacy norms (1)
 

Capital adequacy norms (1)

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    Capital adequacy norms (1) Capital adequacy norms (1) Document Transcript

    • Capital Adequacy Norms - CAR, Introduction, India and ConceptsIntroduction to Capital Adequacy NormsAlong with profitability and safety, banks also give importance to Solvency. Solvency refers tothe situation where assets are equal to or more than liabilities. A bank should select its assets insuch a way that the shareholders and depositors interest are protected .1. Prudential NormsThe norms which are to be followed while investing funds are called "Prudential Norms." Theyare formulated to protect the interests of the shareholders and depositors. Prudential Norms aregenerally prescribed and implemented by the central bank of the country. CommercialBanks have to follow these norms to protect the interests of the customers.For international banks, prudential norms were prescribed by the Bank for InternationalSettlements popularly known as BIS. The BIS appointed aBasle Committee on BankingSupervision in 1988.2. Basel CommitteeBasel committee appointed by BIS formulated rules and regulation for effective supervision of thecentral banks. For this it, also prescribed international norms to be followed by the central banks.This committee prescribed Capital Adequacy Norms in order to protect the interests of thecustomers.3. Definition of Capital Adequacy RatioCapital Adequacy Ratio (CAR) is defined as the ratio of banks capital to its risk assets.Capital Adequacy Ratio (CAR) is also known as Capital to Risk (Weighted) Assets Ratio(CRAR). India and Capital Adequacy NormsThe Government of India (GOI) appointed the Narasimham Committee in 1991 to suggestreforms in the financial sector. In the year 1992-93 the Narasimhan Committee submitted its firstreport and recommended that all the banks are required to have a minimum capital of 8% to therisk weighted assets of the banks. The ratio is known as Capital to Risk Assets Ratio (CRAR).All the 27 Public Sector Banks in India (except UCO and Indian Bank) had achieved the CapitalAdequacy Norm of 8% by March 1997.
    • The Second Report of Narasimham Committee was submitted in the year 1998-99. It recommended that the CRAR to be raised to 10% in a phased manner. It recommended an intermediate minimum target of 9% to be achieved by the year 2000 and 10% by 2002. Concepts of Capital Adequacy Norms Capital Adequacy Norms included different Concepts, explained as follows :- 1. Tier-I Capital Capital which is first readily available to protect the unexpected losses is called as Tier-I Capital. It is also termed as Core Capital. Tier-I Capital consists of :-1.Paid-Up Capital.2.Statutory Reserves.3.Other Disclosed Free Reserves : Reserves which are not kept side for meeting any specificliability.4.Capital Reserves : Surplus generated from sale of Capital Assets. 2. Tier-II Capital Capital which is second readily available to protect the unexpected losses is called as Tier-II Capital. Tier-II Capital consists of :-1.Undisclosed Reserves and Paid-Up Capital Perpetual Preference Shares.2.Revaluation Reserves (at discount of 55%).3.Hybrid (Debt / Equity) Capital.4.Subordinated Debt.
    • 5.General Provisions and Loss Reserves. There is an important condition that Tier II Capital cannot exceed 50% of Tier-I Capital for arriving at the prescribed Capital Adequacy Ratio. 3. Risk Weighted Assets Capital Adequacy Ratio is calculated based on the assets of the bank. The values of banks assets are not taken according to the book value but according to the risk factor involved. The value of each asset is assigned with a risk factor in percentage terms. Suppose CRAR at 10% on Rs. 150 crores is to be maintained. This means the bank is expected to have a minimum capital of Rs. 15 crores which consists of Tier I and Tier II Capital items subject to a condition that Tier II value does not exceed 50% of Tier I Capital. Suppose the total value of items under Tier I Capital is Rs. 5 crores and total value of items under Tier II capital is Rs. 10 crores, the bank will not have requisite CRAR of Rs. 15 Crores. This is because a maximum of only Rs. 2.5 Crores under Tier II will be eligible for computation . 4. Subordinated Debt These are bonds issued by banks for raising Tier II Capital. They are as follows :- 1.They should be fully paid up instruments. 2.They should be unsecured debt. 3.They should be subordinated to the claims of other creditors. This means that the banks holders claims for their money will be paid at last in order of preference as compared with the claims of other creditors of the bank. 4The bonds should not be redeemable at the option of the holders. This means the repayment of bond value will be decided only by the issuing bank. ASSET LIABILITY MANAGEMENT
    • Asset-liability management basically refers to the process by which an institution manages itsbalance sheet in order to allow for alternative interest rate and liquidity scenarios. Banks andother financial institutions provide services which expose them to various kinds of risks likecredit risk, interest risk, and liquidity risk. Asset liability management is an approach thatprovides institutions with protection that makes such risk acceptable. Asset-liability managementmodels enable institutions to measure and monitor risk, and provide suitable strategies for theirmanagement. It is therefore appropriate for institutions (banks, finance companies, leasingcompanies, insurance companies, and others) to focus on asset-liability management when theyface financial risks of different types. Asset-liability management includes not only aformalization of this understanding, but also a way to quantify and manage these risks. Further,even in the absence of a formal asset-liability management program, the understanding of theseconcepts is of value to an institution as it provides a truer picture of the risk/reward trade-off inwhich the institution is engagedCategories of risk1.Credit risk: The risk of counter party failure in meeting the payment obligation on thespecific date is known as credit risk. Credit risk management is an important challenge forfinancial institutions and failure on this front may lead to failure of banks2. Capital risk: One of the sound aspects of the banking practice is the maintenance of adequatecapital on a continuous basis. There are attempts to bring in global norms in this field in order tobring in commonality and standardization in international practices. Capital adequacy alsofocuses on the weighted average risk of lending and to that extent, banks are in a position torealign their portfolios between more risky and less risky assets.3. Market risk: Market risk is related to the financial condition, which results from adversemovement in market prices. This will be more pronounced when financial information has to beprovided on a marked-to-market basis since significant fluctuations in asset holdings couldadversely affect the balance sheet of banks. In the Indian context, the problem is accentuatedbecause many financial institutions acquire bonds and hold it till maturity. When there is asignificant increase in the term structure of interest rates, or violent fluctuations in the ratestructure, one finds substantial erosion of the value of the securities held .4. Interest rate risk: It also considers change in impact on interest income due to changes inthe rate of interest. In other words, price as well as reinvestment risks require focus. In so far asthe terms for which interest rates were fixed on deposits differed from those for which they fixedon assets, banks incurred interest rate risk i.e., they stood to make gains or losses witheverychange in the level of interest rates.As long as changes in rates were predictable both inmagnitude and in timing over the business cycle, interest rate risk was not seen as too serious, butas rates of interest became more volatile, there was felt need for explicit means of monitoring andcontrolling interest gaps.5.. Liquidity risk It is the potential inability to generate adequate cash to cope with a decline indeposits or increase in assets. To a large extent, it is an outcome of the mismatch in the maturitypatterns of assets and liabilities. First, the proportion of central government securities with longermaturities in the Indian bond market, significantly increasing during the 1970s and 1980s,
    • affected the banking system because longer maturity securities have greater volatility for a givenchange in interest rate structure.This problem gets accentuated in the context of change in themain liability structure of the banks, namely the maturity period for term deposits. For instance in1986, nearly 50% of term deposits had a maturity period of more than 5 years and only 20%, lessthan 2 years for all commercial banks. But in 1992, only 17% of term deposits were more than 5years whereas 38% were less than 2 years . Risk measurement techniquesGap analysis model: Definition of Gap Analysis1) The process through which a company compares its actual performance to its expectedperformance to determine whether it is meeting expectations and using its resources effectively.Gap analysis seeks to answer the questions "where are we?" (current state) and "where do wewant to be?" (target state).Value at RiskRefers to the maximum expected loss that a bank can suffer over a target horizon, given a certainconfidence interval. It enables the calculation of market risk of a portfolio for which no historicaldata exists. It enables one to calculate the net worth of the organization at any particular point oftime so that it is possible to focus on long-term risk implications of decisions that have alreadybeen taken or that are going to be taken. It is used extensively for measuring the market risk of aportfolio of assets and/or liabilities.Duration model:Duration is an important measure of the interest rate sensitivity of assets and liabilities as it takesinto account the time of arrival of cash flows and the maturity of assets and liabilities. It is theweighted average time to maturity of all the preset values of cash flows. Duration basic-allyrefers to the average life of the asset or the liability. DP/ p = D ( dR /1+R)The above equation describes the percentage fall in price of the bond for a given increase in therequired interest rates or yields. The larger the value of the duration, the more sensitive is theprice of that asset or liability to changes in interest rates. As per the above equation, the bank willbe immunized from interest rate risk if the duration gap between assets and the liabilities is zero.The duration model has one important benefit. It uses the market value of assets and liabilities
    • Gap analysis model: Definition of Gap Analysis1) The process through which a company compares its actual performance to its expectedperformance to determine whether it is meeting expectations and using its resources effectively.Gap analysis seeks to answer the questions "where are we?" (current state) and "where do wewant to be?" (target state).2) A method of asset-liability management that can be used to assess interest rate risk or liquidityrisk excluding credit risk. Gap analysis is a simple IRR measurement method that conveys thedifference between rate sensitive assets and rate sensitive liabilities over a given period of time.This type of analysis works well if assets and liabilities are compromised of fixed cash flows.Because of this a significant shortcoming of gap analysis is that it cannot handle options, asoptions have uncertain cash flows.Measures the direction and extent of asset-liability mismatch through either funding or maturitygap. It is computed for assets and liabilities of differing maturities and is calculated for a set timehorizon. This model looks at the repricing gap that exists between the interest revenue earned &the banks assets and the interest paid on its liabilities over a particular period of time. GAP refersto the differences between the book value of the rate sensitive assets and the rate sensitiveliabilities. Thus when there is a change in the interest rate, one can easily identify the impact ofthe change on the net interest income of the bank Interest Rate Risk (IRR) The phased deregulation of interest rates and the operational flexibility given to banks inpricing most of the assets and liabilities have exposed the banking system to Interest Rate Risk.Interest rate risk is the risk where changes in market interest rates might adversely affect a banksfinancial condition. Changes in interest rates affect both the current earnings (earningsperspective) as also the net worth of the bank (economic value perspective). The risk from theearnings perspective can be measured as changes in the Net Interest Income (Nil) or Net InterestMargin (NIM). In the context of poor MIS, slow pace of computerisation in banks and theabsence of total deregulation, the traditional Gap analysis is considered as a suitable method tomeasure the Interest Rate Risk. It is the intention of RBI to move over to modern techniques ofInterest Rate Risk measurement like Duration Gap Analysis, Simulation and Value at Risk at alater date when banks acquire sufficient expertise and sophistication in MIS. The Gap orMismatch risk can be measured by calculating Gaps over different time intervals as at a givendate. Gap analysis measures mismatches between rate sensitive liabilities and rate sensitive assets(including off-balance sheet positions). An asset or liability is normally classified as rate sensitiveif:i) within the time interval under consideration, there is a cash flow;ii) the interest rate resets/reprices contractually during the interval;iii) RBI changes the interest rates (i.e. interest rates on Savings Bank Deposits, advances uptoRs.2 lakhs, DRI advances, Export credit, Refinance, CRR balance, etc.) in cases whereinterest rates are administered ; andiv) it is contractually pre-payable or withdrawable before the stated maturities.
    • 8.2 The Gap Report should be generated by grouping rate sensitive liabilities, assets andoffbalance sheet positions into time buckets according to residual maturity or next repricingperiod, whichever is earlier. The difficult task in Gap analysis is determining rate sensitivity. Allinvestments, advances, deposits, borrowings, purchased funds etc. that mature/reprice within aspecified timeframe are interest rate sensitive. Similarly, any principal repayment of loan is alsorate sensitive if the bank expects to receive it within the time horizon. This includes finalprincipal payment and interim instalments. Certain assets and liabilities receive/pay rates thatvary with a reference rate. These assets and liabilities are repriced at pre-determined intervals andare rate sensitive at the time of repricing. While the interest rates on term deposits are fixedduring their currency, the advances portfolio of the banking system is basically floating. Theinterest rates on advances could be repriced any number of occasions, corresponding to thechanges in PLR. The Gaps may be identified in the following time buckets:i) upto 1 monthii) Over one month and upto 3 monthsiii) Over 3 months and upto 6 monthsiv) Over 6 months and upto 12 monthsv) Over 1 year and upto 3 yearsvi) Over 3 years and upto 5 yearsvii) Over 5 yearsviii) Non-sensitiveThe various items of rate sensitive assets and liabilities in the Balance Sheet may be classified asexplained in Appendix - II and the Reporting Format for interest rate sensitive assets andliabilities is given in Annexure II.8.3 The Gap is the difference between Rate Sensitive Assets (RSA) and Rate SensitiveLiabilities (RSL) for each time bucket. The positive Gap indicates that it has more RSAs thanRSLs whereas the negative Gap indicates that it has more RSLs. The Gap reports indicatewhether the institution is in a position to benefit from rising interest rates by having a positiveGap (RSA > RSL) or whether it is in a position to benefit from declining interest rates by anegative Gap (RSL > RSA). The Gap can, therefore, be used as a measure of interest ratesensitivity.8.4 Each bank should set prudential limits on individual Gaps with the approval of theBoard/Management Committee. The prudential limits should have a bearing on the total assets,earning assets or equity. The banks may work out earnings at risk, based on their views oninterestrate movements and fix a prudent level with the approval of the Board/Management Committee.8.5 RBI will also introduce capital adequacy for market risks in due course.9. The classification of various components of assets and liabilities into different time bucketsfor preparation of Gap reports (Liquidity and Interest Rate Sensitivity) as indicated in AppendicesI & II is the benchmark. Banks which are better equipped to reasonably estimate the behaviouralpattern, embedded options, rolls-in and rolls-out, etc of various components of assets andliabilities on the basis of past data / empirical studies could classify them in the appropriate timebuckets, subject to approval from the ALCO / Board. A copy of the note approved by the ALCO /Board may be sent to the Department of Banking Supervision. NPA
    • NPA is a classification used by financial institutions that refer to loans that are in threat of default.Once the borrower has failed to make interest or principal payments for 90 days the loan isconsidered to be a non-performing asset. Non-performing assets are problematic for financialinstitutions since they depend on interest payments for income. Troublesome pressure from theeconomy can lead to a sharp increase in non-performing loans and often results in massive write-downs.With a view to moving towards international best practices and to ensure greatertransparency, it has been decided to adopt the ‘90 days’ overdue’ norm for identification of NPA,from the year ending March 31, 2004. Accordingly, with effect from March 31, 2004, a non-performing asset (NPA) shall be a loan or an advance where;*Interest and/or installment of principal remain overdue for a period of more than 90 days inrespect of a term loan,*The account remains ‘out of order’ for a period of more than 90 days, in respect ofan Overdraft/Cash Credit (OD/CC),*The bill remains overdue for a period of more than 90 days in the case of bills purchased anddiscounted,*Interest and/or installment of principal remains overdue for two harvest seasons but for a periodnot exceeding two half years in the case of an advance granted for agricultural purposes, and*Any amount to be received remains overdue for a period of more than 90 days in respect ofother accounts.Reasons for growing NPAs 1. Economic slowdown - The global economy is still in the throes of an economic crisis that is looming large both in the US and Europe. There is a general slackening of domestic economic activity in India both in manufacturing and the services sectors. A sluggish economy will have a direct impact on the balance sheets and profitability of many firms who have availed of loans from the banking industry. Over a period of time, some of the hard hit firms will be compelled to default on their loans. There is a groundswell of expert opinion in India that NPAs are more an outcome of economic factors rather than any internal systemic failures. 2. High interest rates - It is a known fact that interest rates have been revised upwards, 10 times in the past two years with a view to curb inflation. High interest rate increases the cost of funds to the credit users and has a debilitating effect especially on the repayment capacity of small and medium enterprises. Banks need to maintain their Net Interest Margin and hence pass on any interest rate hike to the borrowers. A high rate of inflation
    • dilutes the quality of assets of the banking sector. Weak supply demand scenario, high borrowing or leveraging and intense competition contribute to loan defaults.3. New reporting system - Indian banks are to report NPAs from April 2012 in a computer recognized / identified format. It is stated that almost 90% of all banks loan portfolio is under the computerized system of NPA reporting or system based reporting. The discretion of bank managers in classifying assets according to their local judgment is eliminated. This change in reporting pattern makes identification of NPAs a machine driven objective activity. However, credit risk analysis does have a subjective and judgmental element to it.4. Aviation sector - The Indian banking system has a total exposure of around Rs. 40,000 crores to the ailing aviation sector. SBI alone has an exposure of 5,000 crores to the aviation industry. It is common knowledge that many airlines are either in the red or marginally profitable. According to an RBI report, nearly three-fourths of the top Banks’ loans to the aviation sector are either impaired or restructured. Kingfisher airlines and Air India have been the significant aviation borrowers whose performance is below par.
    • dilutes the quality of assets of the banking sector. Weak supply demand scenario, high borrowing or leveraging and intense competition contribute to loan defaults.3. New reporting system - Indian banks are to report NPAs from April 2012 in a computer recognized / identified format. It is stated that almost 90% of all banks loan portfolio is under the computerized system of NPA reporting or system based reporting. The discretion of bank managers in classifying assets according to their local judgment is eliminated. This change in reporting pattern makes identification of NPAs a machine driven objective activity. However, credit risk analysis does have a subjective and judgmental element to it.4. Aviation sector - The Indian banking system has a total exposure of around Rs. 40,000 crores to the ailing aviation sector. SBI alone has an exposure of 5,000 crores to the aviation industry. It is common knowledge that many airlines are either in the red or marginally profitable. According to an RBI report, nearly three-fourths of the top Banks’ loans to the aviation sector are either impaired or restructured. Kingfisher airlines and Air India have been the significant aviation borrowers whose performance is below par.